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Opportunity Of A Generation In The Oil Majors

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The current plunge in the price of oil amid the COVID-19 pandemic has set up an opportunity of a generation for contrarian investors willing to take a more long-term view. This opportunity is especially prevalent among the vertically integrated oil majors, in my opinion, whose operations are much more diversified across the value chain which allows them to earn profits throughout the oil cycle. This article will look at and compare U.S. oil giants Exxon Mobil (XOM) and Chevron (CVX) as well as international peers Royal Dutch Shell (NYSE:RDS.A) (RDS.B), BP plc (BP), and TOTAL (Total) (TOT).

ChartData by YCharts


Oil has had an amazingly volatile decade, so the resilience of the oil majors is especially impressive. Out of the entire group, only BP has recorded two net income losses (in 2010 as the company struggled with the Horizon oil spill disaster and again in 2015) and Chevron has recorded one small loss in 2016 amid the slump in oil prices that year. In all the other years, each company has reported profits despite the price of oil with Exxon, Chevron, and Total reporting the highest average profits over the period at 7.4%, 7.2%, and 5.4%, respectively.

Source data from Morningstar

Every company in this peer group is vertically integrated, operating from both the upstream business of extraction, to the downstream business of upgrading and refining the oil into higher valued products. They even go all the way downstream to the retail side of selling these products through gas stations and fuel depots. This vertical integration gives oil majors the opportunity to earn income through numerous parts of the value chain and gives them a greater power over end consumers. Think of how the price of gasoline at the pumps falls less than the price of a barrel of oil.

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In terms of what average return on equity (ROE) each of the oil majors has earned over the past decade, Exxon once again picks up top spot at a 16.0% average ROE, followed by Chevron at 11.2% and Total at 10.9%. These are all impressive returns and when investors are buying that equity at the appropriate price as will be discussed later, it can lead to great returns.

Source data from Morningstar

Price-to-Book Value

The higher profitability of the U.S. majors seems to be reflected in the price, with Exxon and Chevron trading at higher price-to-book values of 0.90x and 1.06x, respectively, as can be seen in the table below. Notably, the international majors are all currently trading at prices well below book value. Return on equity can also be affected by the amount of financial leverage being applied, so keep that in mind when we look at leverage later.

Source data from Morningstar

The U.S. oil majors, with Exxon in particular, have historically traded at higher valuations over the past decade. This valuation could be justified by the higher profitability and if this higher valuation holds, it is all well and good. Regardless, I am a fan of a diversified portfolio and even when I see an industry on sale, I tend to buy a few of my favorites rather than just one.

ChartData by YCharts

Financial Leverage Among the Oil Majors

While the oil majors will definitely suffer in the months to come, their finances tend to be top class. Also, the oil majors’ ability to issue new equity in the markets should not be overlooked. If these companies do need additional financing with the COVID-19 pandemic playing out over a long period, they likely will not be going 100% bankrupt, but only diluting shareholders by issuing more capital. They also look to have room to issue more debt. As can be seen in the graph below, BP is the most financially leveraged at 3.0x in the latest year with its interest coverage ratio being a relatively tight 4.38x. All the other oil majors had healthy interest coverage ratios above 7x in the latest year.

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Source data from Morningstar

Price Ratios and Potential Returns

I always like to examine the relationship between average ROE and price-to-book value in what I call the Investors’ Adjusted ROE. This relationship is especially important for cyclical companies, and is something I consider similar to Shiller’s CAPE ratio but a little simpler to calculate, in my opinion. It examines the average ROE over a business cycle and adjusts that ROE for the price investors are currently paying for the company’s book value or equity per share. For example, with Exxon earning an average ROE of 16.0% over the past decade and shares currently trading at a price-to-book value of 0.90x when the price is $40.96, this would yield an Investors’ Adjusted ROE of 17.8% for an investor’s equity at that purchase price, if history repeats itself. This is well above the 9% that I like to see, even before adding a 3% growth rate to represent the company growing alongside GDP, which could increase this potential total return up to 20.0%.

Source data from Morningstar and author’s calculations

As can be seen in the table above, Exxon carries the highest Investors’ Adjusted ROE at 17.8%, followed by Total at 15.1% and Royal Dutch Shell at 14.4%. As witnessed by Chevron’s low 10.5%, the much higher price-to-book value of Chevron seems unwarranted given its average ROE being mostly similar to peers. BP comes in last with an 8.3% investors’ adjusted ROE and even if we exclude 2010’s ROE from the average when the Horizon oil spill happened, the Investors’ Adjusted ROE is still only 10.1%. That being said, all of these potential returns look enticing.

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The current plunge in the price of oil amid the COVID-19 pandemic has set up an opportunity of a generation for contrarian investors willing to take a more long-term view. Exxon carries the highest Investors’ Adjusted ROE at 17.8%, followed by Total at 15.1% and Royal Dutch Shell at 14.4%. These companies are all nicely profitable and well-capitalized to ride out the COVID-19 pandemic.

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Disclosure: I am/we are long BP, TOT, RDS.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. The material is intended only as general information for your convenience, and should not in any way be construed as investment advice. I advise readers to conduct their own independent research to build their own independent opinions and/or consult a qualified investment advisor before making any investment decisions. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles.

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